Interest rate: what is it, what is it used for and what types are there?

As part of the implementation of a unified state monetary policy, the Bank of Russia is granted by law the right to provide loans to commercial banks for various purposes:

• commercial banks experiencing difficulties in ensuring uninterrupted settlements (payments);
• commercial banks experiencing difficulties in providing liquidity in accordance with the requirements of the Bank of Russia and as a result of the threat of non-fulfillment of their obligations to counterparties (depositors, clients, creditors, etc.), including within the framework of the emergency liquidity provision mechanism;
• lending to commercial banks in order to expand their expansion in the credit market and increase the non-cash money supply in circulation in accordance with the guidelines of the unified state monetary policy;
• to influence the size of interest rates in the interbank lending market, as part of the implementation of the policy of regulating financial markets using monetary policy instruments;
• to provide support to financial markets during crisis periods in the development of the Russian economy;
• providing loans to commercial banks for any other purposes not related to the above.

All loans that the Bank of Russia provides to commercial banks (credit organizations) can be divided into two large groups:
Group I – Bank of Russia loans of permanent validity.

These include overnight loans, intraday loans, loans secured by claims under loan agreements and pawn loans, with a maturity of 1 to 30 business days and they can be used by credit institutions (commercial banks) on any business day. This mechanism is used mainly for the uninterrupted implementation of non-cash payments by credit institutions in order to ensure sustainability and ensure the uninterrupted functioning of the Russian payment system;

Group II – Specialized refinancing mechanisms.

Also, for the development of various sectors of the Russian economy, in order to increase their competitiveness, positive development dynamics, support export potential, modernization, renewal of fixed production assets within the framework of federal target programs and government assignments in the field of social support, the Bank of Russia uses
specialized lending mechanisms from commercial banks,
through which the above goals are realized.

Also, from September 1, 2021, the Bank of Russia has been using mechanisms for emergency provision of liquidity and provision of loans under irrevocable credit lines for commercial banks that are experiencing serious difficulties in meeting payments and obligations. In addition, in 2014-2016, the Bank of Russia, in connection with the use of US and EU sanctions against Russian banks, began to use a mechanism for providing emergency loans to Russian banks in foreign currency.

In accordance with the law, the Bank of Russia can provide loans only to Russian credit organizations (commercial banks) subject to the following conditions:

• the credit institution corresponds to the 1st or 2nd classification group based on the results of assessing its financial position in accordance with the methodology of the Bank of Russia;
• to credit institutions classified in the 3rd classification group, if the loans provided to them are classified as secured by the pledge of liquid securities;
• there is no underpayment of mandatory reserves deposited in an account with the Bank of Russia in accordance with the regulatory documents of the Bank of Russia, and there are also no fines for violating mandatory reserve requirements;
• complies with the deadlines for submitting to the Bank of Russia the calculation of mandatory reserve requirements (the amount of required reserves).

At the moment, the Bank of Russia sets the following interest rates for specialized instruments (in % per annum):

Classification of interest rates

All existing types of interest rates can be classified according to the following main criteria:

1. Depending on variability over time;
2. Depending on the moment of payment of dividends;
3. Depending on the inflation rate.

Fixed and floating interest rates

Depending on whether the interest rate changes over time or not, the following two types are distinguished:

1. The fixed rate is set once and is not subject to revision throughout its entire validity period;
2. The floating rate, as is already clear from the context, can change over time. As a rule, it is tied to any specific value (for example, to the inflation growth rate or to the interbank rate LIBOR**).

A fixed rate is good for its predictability and allows you to plan your actions for servicing it in advance. For example, a borrower who decides to take out a loan at a fixed interest rate per annum can see in advance the full picture of monthly payments throughout the entire loan repayment period and thus assess his ability to repay it.

Let's look at a simple example. A loan in the amount of 1,000,000 rubles for one year, at a fixed rate of 15% per annum.

In this case, when repaying the loan with annuity (equal) payments, the amount of each of them will be the sum of current interest on the balance of the debt and part of the debt itself. Moreover, with each month, as the end of the loan term approaches, the part of the repaid debt will increase, and the amount of interest payments on the balance will correspondingly decrease:

Unlike a fixed interest rate, a floating interest rate can change in either a favorable or unfavorable direction for the borrower. This means that with its help you can either save on loan servicing or get into even greater debt bondage (especially for long-term mortgage loans).

By issuing loans at a floating interest rate and tying it, for example, to the refinancing rate, banks almost completely remove interest rate risk. After all, at the refinancing rate they can be financed by the Central Bank of the Russian Federation. Therefore, issuing loans to its clients at a rate equal to:

Floating interest on loan = Refinancing rate + Fixed premium

They pledge their guaranteed profit in the form of a fixed premium, which is usually 2...5%.

Banks always take into account all their risks and when issuing a loan at a fixed rate, they initially make it somewhat overpriced (unlike loans issued at a floating interest rate). For example, at the same time, a bank can issue a loan at a fixed rate of 12% per annum and at a floating rate of 10%. That is, it turns out that at the time of applying for a loan, the most profitable is the floating rate. However, as mentioned above, in the process of repaying the loan, the value of the floating rate may well change upward, thus negating all the initially received benefits.

** LIBOR – London Interbank Offered Rate, is the weighted average interest rate on loans provided by the largest banks in London. Calculated daily and serves as the basis for many other interest rates. For example, writing LIBOR+3% would mean that the interest provided would be 3% higher than LIBOR.

Decursive and anticipatory interest rates

Depending on when the interest rate will be paid, there are two more types:

1. A decursive interest rate involves the payment of interest at the end of its term, along with the return of the principal amount;
2. The anticipatory rate, on the contrary, provides for the payment of interest at the very beginning of using borrowed funds.

For example, for the same loan of 1,000,000 rubles at 15%, for a period of one year, interest payments will be made as follows:

• With a decursive interest rate, the lender will transfer the amount of 1,000,000 rubles to the borrower immediately upon conclusion of the loan agreement. And he, in turn, will pay the creditor 1,150,000 rubles in exactly one year;
• With an anticipatory rate, the lender will transfer the amount to the borrower minus the interest due on it. That is, in this case, its size will be 850,000 rubles (1000000-150000=850000). And at the end of the loan period (after one year) he will receive 1,000,000 rubles.

Thus, it turns out that the decursive rate on the loan is more beneficial to the borrower (he receives more money by paying the same amount of interest), and the anticipatory rate is more beneficial to the lender (he receives the same profit by borrowing a smaller amount of money).

Real and nominal interest rates

Depending on whether the inflation rate is taken into account or not taken into account when calculating the interest rate, two more types can be distinguished:

1. Real. When calculating it, the level of current inflation is taken into account;
2. Nominal. Calculated without taking into account inflation.

Real and nominal interest rates, as well as the inflation rate, are interconnected by a certain relationship:

This dependence is called after the American economist Irving Fisher, and you can read more about it here: The Fisher Effect in simple words.

A simple example: if a profit of 200,000 rubles is received from invested funds of 1,000,000 rubles, then this will correspond to a nominal interest rate of 20%. And if inflation is 3%, then the real interest rate will be equal to 17% (20-3=17).

That is, if during the same time (while this money is invested), the average inflation rate in the country is 3%, then the investor’s real earnings will already be this three percent less. He will, of course, receive 200 thousand in his hands, but by this time their purchasing power will have already decreased by the percentage of inflation. And now, with the 200,000 rubles received, it will be possible to purchase the same number of goods and services as previously (before the start of the investment period) it was possible to buy for 170,000 rubles.

What determines the final overpayment?

Overpayment - be it a consumer or targeted loan - depends on three parameters:

1. Amount issued - the more issued, the more interest you will have to pay in absolute terms;
2. Duration of use of the loan. According to the legislation of the Russian Federation, clients are obliged to pay the bank not for the fact of issuing a loan, but for the time during which the client uses the loan. Thanks to this, the borrower can save significantly if he takes out a loan for a short period or if he repays it early. But this also becomes a stumbling block, because... Most borrowers mistakenly interpret the term “annual interest rate” because of this;
3. The size of the interest rate itself. Everything is simple here - the higher the rate, the more you need to pay (both in absolute and percentage terms).

So, let's look at it with an example. Let’s say a client has a choice of two loan offers:

• According to the first, the borrower will be given at least 300 thousand rubles, because the minimum loan amount is 300 thousand, the interest rate is 15% per annum, the minimum period for repayment of debt, not counting the possibility of repaying the debt ahead of schedule, is from one year;
• According to the second option, the loan term is fixed - no more than 6 months. The maximum amount is 250 thousand rubles, the rate is 18% per annum.

Looking at these offers, at first it will seem that the first one is more profitable, especially if you take it for a period of more than 1 year. But in fact, in absolute numbers, the client will pay significantly more in the first case.

Let's say that in the first example he takes the minimum 300 thousand rubles, in the second - the maximum 250 thousand. In the first case, he takes them for one year, in the second case, for six months. Then the amount of overpayment for the first offer will be 45 thousand rubles, and for the second loan - exactly half as much, 22,500 rubles. Although, it would seem, there should not be such a significant difference. What's the matter?

It's a matter of time during which the debt is paid off. As we said, the client pays for the time of use. If the loan is taken out for a year, the entire annual interest rate is realized - 15% in the first example. If the loan is taken out for two years, it turns out to be 15% in the first year and another 15% in the second. And so on.

In addition, the above overpayment amount will only be relevant if the debt is paid at once, in one payment at the end of the term. If you repay the debt monthly, the total amount of overpayment will decrease even more. Why?

Because the amount of the overpayment is calculated from the amount of the principal debt that the borrower currently has. That is, if you had 150 thousand rubles, and the next month you reduced the debt to 50 thousand, the interest will be calculated from exactly fifty thousand. That is why early loan repayment and short loan terms are very beneficial from the point of view of overpayment.

Risk-free interest rate

This is the name given to the interest rate on a financial instrument with a relatively low level of risk. For example, the coupon rate on government bonds, which are considered the most reliable securities. Or, the rate on a bank deposit can be considered risk-free, since all deposits of individuals are subject to the state insurance program**

Please note that the word “risk-free” in this case does not mean the complete absence of risk.

There is always risk in investments, and the greater their potential return, the higher the level of risk. This is why the profitability of financial instruments with a risk-free interest rate is at a minimum level (often it barely exceeds the inflation rate).

When investing even in the most reliable government bonds and bank deposits, you may encounter such risks as:

• Unfavorable interest rate change;
• Political changes;
• Risk of default;
• Other Unforeseen Liabilities.

Why was the concept of risk-free interest rate introduced? The fact is that everything in this world is relative and strongly depends on the specific starting point from which the assessment is made. So in this case, the risk-free rate serves as the starting point for calculating and assessing interest rates on other financial instruments.

The effectiveness of an investment can be assessed by the number of points by which its interest rate exceeds the risk-free level. For example, the interest rate on corporate bonds of 14% per annum looks very attractive compared to the 8% that is given on bank deposits.

The risk-free interest rate can be of two main types:

1. Common noun;
2. Real.

The nominal rate is understood as the interest rate on financial instruments with a maximum level of reliability and a minimum level of risk (as in the examples discussed above with government bonds and bank deposits). And the real one is the nominal risk-free rate minus the current inflation rate.

When assessing the attractiveness of an investment project, they look specifically at the real risk-free interest rate, which in this case acts as the risk premium that the investor will receive as a result of the successful implementation of the project in question.

** Up to a deposit amount not exceeding 1,400,000 rubles.

Calculation of bank interest

In financial practice, it is customary to calculate bank interest in annual terms. This means that if the bank indicates that the rate of funds accepted for deposit is, for example, 10% per annum, you receive an amount greater than this 10%, accrued during the year. If you need to calculate how much it will be per month or per day, simply divide the interest rate by the time period you need. To find out how much you will receive per month, you need to divide 10% by 12 (the number of months in a year). And to calculate the interest per day, you will need to divide the interest rate by 365 (the number of days in a year).

Forward interest rate

In cases where it is necessary to hedge your risks arising from a possible change in the level of interest income, a forward interest rate is used. It is established immediately at the time of conclusion of the contract, and is valid for a specific set date in the future.

Forward rates are sometimes also used to forecast future spot rates, but many economists question the accuracy of these types of forecasts.

To calculate forward interest rates on bond coupon payments, the following formulas can be used:

Hedging the risk of changes in interest rates can be carried out through a forward contract. In this case, the seller of such a contract hedges the risk of lower interest rates at a specific (established in the contract) date in the future. And the buyer, accordingly, is insured against the fact that they will increase. Upon the expiration date of the contract, depending on which direction the actual change in rates occurred, the parties make mutual settlements among themselves. If rates have decreased, the buyer pays the seller the difference between their current value and the one specified in the forward contract. Accordingly, when rates increase, the difference is paid by the seller of the contract.

Dependence of the forward interest rate on the period for which the forward contract is concluded on it

The shape of the curve in the above figure clearly shows the dependence of the forward rate on the term of the forward contract. It has an increasing nature due to the fact that the value of money today is always higher than its value in the future, and therefore the forward rate must compensate for this difference, and in addition it must provide a certain compensation (depending on the amount of risk taken) called the liquidity premium.

The bending of the curve in the form of a hyperbola is explained by the fact that as the time until the expiration date decreases, the size of the liquidity premium decreases.

Simple and complex bank interest

Bank interest can be calculated in two ways, called simple and compound interest. In the first case, it is understood that the loan (deposit) amount is always taken as the basis for calculations during the term of the agreement. Compound interest takes into account that in each subsequent period the amount on which interest is calculated increases by the amount of interest received in the previous period.

Traditionally, deposits on which the bank charges compound interest are considered more profitable. The situation with loans is the opposite. Interest is considered beneficial if it is calculated not on the entire loan amount, but on the balance of funds not returned to the bank.

Overnight interest rate

Literally translated from English, the word “overnight” means through the night. This rate is offered for deposits placed for a period of one day. Typically, such deposits are closed (with interest paid on them) on the next business day after they are opened, and if it falls on a weekend, then on the first business day.

Overnight deposits are available only to relatively large clients who have sufficiently large amounts of funds to open them. These are mainly large companies, banks and other financial organizations. Storing money in deposits of this kind allows, on the one hand, to maintain current short-term liquidity at the proper level, and, on the other hand, to extract a certain percentage of profit from available funds.

Due to the very short period of deposits, the overnight interest rate is not too high, but it is usually higher than the rate on demand accounts.

The overnight rate depends on factors such as:

1. Cyclical factors. These include the end-of-the-month effect (associated with the preparation of bank reports) and the end-of-averaging period effect (meaning averaging on banks’ required reserves associated with an increase in demand for liquidity and, consequently, with an increase in the overnight interest rate);
2. Economic forces. Here, the dominant role is played by such factors as current expectations regarding changes in the key rate of the Central Bank and the emerging situation in the government securities market and the foreign exchange market.

In addition, the overnight rate may increase during periods of financial crises against the backdrop of a decrease in banks’ trust in each other and a decrease in the volume of transactions they conduct.

The size of this rate, as well as its stability, have a great impact on the economic situation in the country as a whole. If its values ​​are relatively stable and do not go beyond a narrow corridor, then this, in addition to market participants’ access to short-term liquidity, also gives them the opportunity to effectively redistribute liquidity and plan its management.

That is why central banks pay considerable attention to the issue of the current level of overnight interest rates and strive to keep their values ​​within a certain percentage range. This becomes especially relevant for them in the process of inflation targeting.

Each country has its own benchmark for overnight interest rates. For example, in Russia it is RUONIA, in the USA - SOFR, in Japan - TONAR, etc.

How not to lose money

Read the contract carefully

The law has provided a special frame in which the full amount of the loan is entered. Ignoring it is criminal negligence for your budget. Read the contract in its entirety and carefully, do not skip paragraphs, even those written in small print. Don't hesitate to ask questions to the manager.

Once you have signed the contract, you have agreed to everything that is written there. Therefore, resolve any discrepancies before autographing a document.

Don't make late payments

Set a reminder on your phone, computer and microwave, and circle the payment days in the calendar with red circles. Please note when these dates fall on a weekend to ensure your payment is credited in advance. Punctuality will help you avoid fines and penalties for late payments. And the amount of penalties can be quite significant.

If you can repay the loan early, pay it off

Interest is calculated on the principal amount. Early payments make it less. Therefore, the faster you repay the loan, the less you overpay.

Do not take long-term loans in foreign currency

The interest rate on foreign currency loans is lower, but dollars or euros must be stable for the loan to be cheaper than its ruble counterpart. Unless you have the gift of clairvoyance and unbridled optimism, it will be difficult for you to predict currency fluctuations in the long term.

You will be able to repay a small loan quickly, even if something goes wrong. When the ruble falls, a long-term foreign currency loan will turn into an unbearable burden that will drain all the money from you to service yourself, that is, on interest.

Be frivolous

Keep a close eye on your pennies. This is 5 kopecks for you - a coin unworthy even to prop up a table leg. For the bank, a delay in this amount is grounds to fine you. You are also lucky if the sanctions are calculated as a percentage of the overdue amount. What if it’s in interest on the principal debt?

Follow the terms of the contract

It’s not for nothing that you read the contract, follow what is written in it. For example, if you forget to renew the insurance, thanks to which you were offered favorable mortgage terms, the bank may increase the interest rate. And it will be more difficult to reverse this process.

Keep in touch with the bank

If an employee of a credit institution tries to contact you, pick up the phone and open the SMS. It’s better to read the advertisement for the hundredth time than to miss a message about overdue or other important information.

Use your credit card wisely

Pay off credit card debts during the interest-free period and do not withdraw cash from it, as this most often incurs a commission.

Interbank interest rates

This is what is commonly called interest rates on loans on the interbank market. According to them, banks can interact with each other both to maintain their own liquidity and to place temporarily free money (those that could not be placed more profitably, for example, in the form of loans to the population).

In Russia these include:

Rates MIBID, MIBOR, MIACR

1. MIBID – Moscow Interbank Bid Rate. The average rate at which the largest banks in Moscow attract interbank loans;
2. MIACR – Moscow Interbank Actual Credit Rate. This rate represents a weighted average value (depending on the actual volume of transactions) of the percentage at which the largest banks in Moscow are ready to provide loans on the interbank market;
3. MIBOR – Moscow Interbank Offered Rate. At this rate, the largest Moscow banks place loans on the interbank market (its average value is also taken);
4. INSTAR – Interbank Short-Term Actual Rate. Interest rates on the Moscow interbank market calculated on the basis of actual transactions between banks.

Interbank interest rate INSTAR

The most famous interbank interest rates in the world are:

• LIBOR – London Interbank Offered Rate. The average rate for providing interbank loans set by the largest banks in London;
• BIBOR – Bangkok Intebank Offered Rate. Rate on foreign currency deposits in the interbank market of Bahrain;
• PIBOR – Paris Interbank Offered Rate. Interbank interest rate set by Parisian banks;
• SIBOR – Singapore Interbank Offered Rate. The average rate at which loans are provided (for relatively short periods) by Singapore banks;
• FFR – Federal funds rate. The rate at which US banks provide overnight loans to each other;
• EURIBOR – European Interbank Offered Rate. Average rate on loans in the single European currency (Euro).

Types of bank interest

In banking practice, there are several types of interest:

• loan (credit),
• deposit,
• discount,
• accounting

Loan interest is the amount that is charged to the borrower for using loan funds. Deposit interest is essentially the same as loan interest, but the borrower in this case is a banking institution that pays you a fee in the form of this same deposit interest for the use of your money.

The discount percentage assumes the amount of discount from any amount in a monetary transaction. The discount rate is the rate determined by the Central Bank at which this institution issues borrowed funds to other banks.

What does the loan cost include?

The borrower needs to know not only what the interest rate is, but also what the loan includes. It is calculated based on:

• inflation level: in Russia it is approximately 7% per year;
• the bank does not issue its own funds, for this it has depositors: servicing deposits requires funds that are included in the loan;
• in some cases, banks themselves borrow funds from other organizations, and borrowers pay interbank interest;
• Each bank has defaulters, which is also included in the cost of the loan;
• The bank takes into account its development: it needs to pay salaries to employees, cover other expenses, for which clients also pay.

Taking into account these calculation rules, we can say what the interest rate is. This is compensation for the bank's expenses for its needs and to make a profit.